Skip to main content
SpringerLink
Log in

A good pair: alternative pairs-trading strategies

  • Published:
Financial Markets and Portfolio Management Aims and scope Submit manuscript

Abstract

This paper studies alternative techniques for identifying stock pairs in a pairs-trading strategy over 1980–2014. We consider two main techniques: the distance approach and the cointegration approach. We also consider a range of parameterizations of the trading system design. Parameterization of the trading system matters for the profitability of pairs trading. We find that the cointegration approach, despite using an optimal in-sample parameterization, yields significant returns only in the 1980s. The distance approach performs better, producing significantly positive risk-adjusted returns in all sub-periods. However, when transaction costs are properly taken into account, the returns largely disappear in recent years.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5
Fig. 6
Fig. 7

Similar content being viewed by others

Notes

  1. Specifically, the cointegration approach is often motivated in terms of common stochastic trends that arise from common fundamentals for the two securities. Vidyamurthy (2004) and others relate the cointegration model to the arbitrage pricing theory.

  2. Specifically, we use the algorithm “jcitest” in Matlab, the description of which is: “Johansen tests assess the null hypothesis H(r) of cointegration rank less than or equal to r among the numDims-dimensional time series in Y against alternatives H(numDims) (trace test) or H(r+1) (maxeig test). The tests also produce maximum likelihood estimates of the parameters in a vector error-correction (VEC) model of the cointegrated series”.

  3. Gatev et al. (2006) suggest that data-snooping bias is a reason to avoid exploring alternative parameterizations. Data-snooping bias is a valid argument, of course, but surely institutions that trade pairs, such as hedge funds, have studied alternative parameterizations. However, those studies would be largely proprietary. The present study is not.

  4. This is consistent with anecdotal evidence from the industry. For example, Schmerken (2006) reports that “[p]airs trades usually are meant for investors looking for a short-term profit in the market”. “The average time for a trade to be open is 15 days”, says LCM’s Gaubert. “A position could be held as long as a month”.

  5. Jensen’s alpha is estimated for each sub-period by regressing the monthly pairs-portfolio returns on a constant (Jensen’s alpha) and the market return net of the risk-free rate. The same procedure is used below to estimate the Fama-French four-factor model. Data for the market excess return, as well as the other variables used in the Fama-French four-factor model considered below, are obtained from Kenneth French’s website (https://doi.org/mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). Reported t-statistics in the market model and Fama-French model are robust to heteroscedasticity and autocorrelation.

  6. A normal distribution has a skew of 0 and a kurtosis of 3.

References

  • Baronyan, S., Boduroglu, I.I., Sener, E.: Investigation of Stochastic Pairs Trading Strategies Under Different Volatility Regimes. Manch. School 78(s1), 114–134 (2010)

    Article  Google Scholar 

  • Bolgun, K.E., Kurun, E., Guven, S.: Dynamic Pairs Trading Strategy for the Companies Listed in the Istanbul Stock Exchange. Int. Rev. Appl. Financ. Issues Econ. 1, 37–57 (2010)

    Google Scholar 

  • Bookstaber, R.: \(A\) Demon Of Our Own Design. Wiley, New York (2006)

    Google Scholar 

  • Bramante, R.: An Approach to Ranking the Hedge Fund Industry. In: Giudici, P., Ingrassia, S., Vichi, M. (eds.) Statistical Models for Data Analysis, pp. 63–71. Springer, New York (2013)

    Chapter  Google Scholar 

  • Broussard, J.P., Vaihekoski, M.: Profitability of Pairs Trading Strategy in an Illiquid Market with Multiple Share Classes. J. Int. Financ. Mark. Inst. Money 22(5), 1188–1201 (2012)

    Article  Google Scholar 

  • Caldeira, J.F., Moura, G.V.: Selection of a Portfolio of Pairs Based on Cointegration: A Statistical Arbitrage Strategy. Rev. Braz. Financ. 11(1), 49–80 (2013)

    Google Scholar 

  • Chen, H., Chen, S., Li, F.: Empirical Investigation of an Equity Pairs Trading Strategy. Mimeo, New York (2012)

    Book  Google Scholar 

  • Deaves, R., Liu, J., Miu, P.: Pairs Trading in Canadian Markets: Pay Attention to Inattention. Canadian Investment Review, Analysis and Research (2013)

    Google Scholar 

  • Do, Binh: Faff, Robert: Does Simple Pairs Trading Still Work? Financ. Anal. J. 66(4), 83–95 (2010)

    Article  Google Scholar 

  • Do, B., Faff, R.: Are Pairs Trading Profits Robust to Trading Costs? J. Financ. Res. 35(2), 261–287 (2012)

    Article  Google Scholar 

  • Elliott, R., Van Der Hoek, J., Malcolm, W.: Pairs Trading. Quant. Financ. 5(3), 271–276 (2005)

    Article  Google Scholar 

  • Engelberg, J., Gao, P., Jagannathan, R.: An Anatomy of Pairs Trading: The Role of Idiosyncratic News. Common Information and Liquidity. Mimeo, New York (2009)

    Google Scholar 

  • Gatev, E., Goetzmann, W., Rouwenhorst, G.: Pairs Trading: Performance of a Relative-Value Arbitrage Rule. Rev. Financ. Stud. 19(3), 797–827 (2006)

    Article  Google Scholar 

  • Gregory, I., Knox, P., Oliver-Wald, C.: Analytical Pairs Trading Under Different Assumptions on the Spread and Ratio Dynamics. Mimeo, New York (2011)

    Google Scholar 

  • Herlemont, D.: Pairs Trading, Convergence Trading, Cointegration. Working paper, YATS Finances & Technologies, USA (2004)

  • Huck, N.: Pairs Selection and Outranking: An Application to the S&P 100 Index. Eur. J. Oper. Res. 196(2), 819–825 (2009)

    Article  Google Scholar 

  • Huck, N.: Pairs Trading and Outranking: The Multi-Step-Ahead Forecasting Case. Eur. J. Oper. Res. 207(3), 1702–1716 (2010)

    Article  Google Scholar 

  • Jacobs, H., Weber, M.: Losing Sight of the Trees for the Forest? Attention Allocation and Anomalies. Mimeo, New York (2013)

    Google Scholar 

  • Kanemura, T., Rachev, S.T., Fabozzi, F.: The Application of Pairs Trading to Energy Futures Markets. mimeo, New York (2008)

  • Lehmann, B.: Fads, Martingales and Market Efficiency. Q. J. Econ. 105(1), 1–28 (1990)

    Article  Google Scholar 

  • Lin, Y., McCrae, M., Gulati, C.: Loss Protection in Pairs Trading Through Minimum Profit Bounds: A Cointegration Approach. J. Appl. Math. Decis. Sci. 2006, 1–14 (2006)

    Article  Google Scholar 

  • Lucey, M., Walshe, D.: European Equity Pairs Trading: The Effect of Data Frequency on Risk and Return. J. Bus. Theory Pract., 329–341 (2013)

    Article  Google Scholar 

  • Mudchanatongsuk, S., Primbs, J., Wong, W.: Optimal Pairs Trading: A Stochastic Control Approach. In: American Control Conference, pp. 1035–1039 (2008)

  • Nath, P.: High Frequency Pairs Trading with US Treasury Securities: Risks and Rewards for Hedge Funds. Mimeo, New York (2003)

    Google Scholar 

  • Papadakis, G., Wysocki, P.: Pairs Trading and Accounting Information. Mimeo, New York (2007)

    Google Scholar 

  • Peng, L., Xiong, W.: Investor Attention, Overconfidence and Category Learning. J. Financ. Econ. 80, 563–602 (2006)

    Article  Google Scholar 

  • Perlin, M.S.: Evaluation of Pairs Trading Strategy at the Brazilian Financial Market. J. Deriv. Hedge Funds 15(2), 122–136 (2009)

    Article  Google Scholar 

  • Schmerken, I.: Finding the Perfect Pair. Wall Street Technol. 24(7), 1 (2006)

    Google Scholar 

  • Tourin, A., Yan, R.: Dynamic Pairs Trading using the Stochastic Control Approach. J. Econ. Dyn. Control 37, 1972–1981 (2013)

    Article  Google Scholar 

  • Vidyamurthy, G.: Pairs Trading-Quantitative Methods and Analysis. Wiley, New York (2004)

    Google Scholar 

Download references

Acknowledgements

We are grateful to two referees for suggestions. This paper represents the views of the authors and does not represent the views, practices, or policies of Vestcor Investment Management Corporation.

Author information

Authors and Affiliations

  1. Department of Economics, University of Alberta, 8-14 Tory Building, Edmonton, AB, T6G 2H4, Canada

    R. Todd Smith

  2. Vestcor Investment Management Corporation, Fredericton, NB, Canada

    Xun Xu

Authors
  1. R. Todd Smith
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Xun Xu
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to R. Todd Smith.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Smith, R.T., Xu, X. A good pair: alternative pairs-trading strategies. Financ Mark Portf Manag 31, 1–26 (2017). https://doi.org/10.1007/s11408-016-0280-x

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11408-016-0280-x

Keywords

JEL Classification

Search

Navigation